Family Dollar: Get a Deal or Take a Discount

Family Dollar Stores exhibits all the hallmarks of a classic LBO candidate: steady cash flow, low levels of debt, operations that need improvement and an earnings-related stock dip. Two other factors only increase the likelihood of a buyout: a management insider with whom to strike a friendly deal and an activist serving as a catalyst.

Still, Nelson Peltz is unlikely to prevail. The roughly $7.5 billion offer from his Trian Group is a stretch. It does, however, open the door to another bidder with more financial wherewithal. And management would be wise to take a good close look because shareholders are unlikely to see this kind of value anytime soon under other scenarios.

In January, the discount retailer reported its best fiscal first-quarter results in more than 12 years and reaffirmed targets for expansion and sales at stores open more than a year. Still, earnings and the targets were below what analysts expected, and the stock continued its decline from a high of $51.07 in early December to a low of $41.49 in early February.

Bloomberg News

Family Dollar’s earnings before interest, taxes, depreciation and amortization, or Ebitda, margins strengthened through the recession from 7.4% for the fiscal year ended August 2008 to 9.5% in 2010, partially on consumers trading down from higher priced retailers.

This strong performance allowed the company to reinvest in new stores while keeping long term debt at a modest $250 million (or 0.3 times Ebitda).

Despite such performance, there remains room for improvement. Margins are under pressure as the chain increases its grocery offerings, which have lower margins, and introduces more national brands. Unfortunately for shareholders, margins will probably get worse before they get better, owing to the costs of developing private-label alternatives and renovating stores to retain customers as the economy improves.

CEO Howard Levine is the son of Family Dollar’s founder and controls 7.8% of the company. He has been asked to participate in the Trian deal, and his interest in any deal will be key. He might be less receptive to bids from competitors such as Dollar General.

Levine has already responded to demands from Peltz since Trian first invested last year. In October the company executed a $250 million accelerated share repurchase under a $750 million dollar stock repurchase authorized by the board in September. The repurchases to date have been made with cash on hand, but the company issued $300 million of new notes this month to complete the program by the fall.

Peltz has doubled his stake to 8% but his offer of $55 to $60 a share remains highly conditional and he will likely need additional backers to muster the estimated $2 billion to $2.5 billion of equity required for an $8 billion dollar LBO.

His move put Family Dollar in play, however, and the company has retained Morgan Stanley.

Management should engage with other potential bidders who could more easily come up with the equity, but it shouldn’t expect any other offers to come in much higher. Trian’s offer amounts to about 9 times expected Ebitda, or 10 times Enterprise value/Ebitda. That isn’t much less than the 11 times EV/Ebitda that KKR paid for Dollar General at the height of the LBO bubble, and Dollar General had significantly lower margins that were readily improved upon.

Nomura has published a scenario in which Family Dollar could ultimately be valued at $100 a share based on a fully optimized business with significant increases in sales per square foot. But that is a long term bet for a private-equity player to attempt to realize, not one that public investors will pay up for. Many of the current shareholders have bought into a potential takeout.

Achieving such a performance level also has to be weighed against the risk that Wal-Mart Stores pursues a small-store strategy and interrupts Family Dollar’s progress.

Bidding will also be constrained by the fact that alternative discount retail assets are available for sale in the form of BJ’s Wholesale Club and Big Lots. Absent a formal deal, Family Dollar management and shareholders have to contemplate the alternative. Trian’s conditional offer is 40% to 50% above where the stock was before Trian bought in and 6% to 16% above the recent high. If Peltz is spurned and exits his 8% stake, the stock is likely to fall below recent lows into the $30s.

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